Reason Foundation

Bair on U.S. Bond Bubble Possibility

The United States government, the Fed and financial markets don't have a great track record when it comes to spotting bubbles. The financial markets missed the dot com bubble in the late 90's and, more recently, the Fed didn't pay close enough attention to the housing bubble, which peaked back in 2006. Is it possible that we could be in the midst of yet another bubble?

There are potentially multiple bubbles starting to inflate, but In a column published last week in Fortune, former FDIC chairwoman, Sheila Bair (whom we've highlighted opinions from in the past), focuses on one potential bubble in which we may be in the middle of. She argues that the U.S. is currently experiencing a bond bubble that is being fueled by the Federal Reserve. Bair argues:

"The Fed has maintained interest rates at or near zero for four years running, even though the financial system has been relatively stable since 2009. The Fed's actions have kept Treasury bond prices high (while keeping the government's interest costs low), but the fundamentals do not support the high valuations, given the fiscal mess we are in."

Her argument is dead on. The Fed has maintained a zero interest rate policy since late 2008 and actively pursued policies designed to further lower interest rates on bonds (ex. Operation Twist, though it didn't quite work). What has been the result? When you look at countries in terms of their debt-to-GDP ratios, the United States (estimated at 104.8%) is among the likes of Ireland (104.9%), Portugal (110%), and Italy (120%). But unlike our undistinguished company, we have fairly low bond yields on 10-year treasury bonds compared with the yields on comparable 10 year (9 year for Ireland) government issued bonds from the previously mentioned countries (1.88% compared to 6.82%, 11.06%, and 5.44% respectively). This translates to higher prices on U.S. bonds (hence the inflating bubble analogy) than we should theoretically have.

Bair acknowledges that defenders of the Fed's policies will point to Japan as an example of a country, which has run up huge debts without experiencing a bond bubble burst. And in some respects we are similar to Japan, which has an astronomically high debt to GDP ratio (at 233.1%), yet only a 0.92% yield on its 10-year bonds. But Bair points out some key differences.

"Japan enjoys a trade surplus, and its debt is held domestically. In contrast we run persistent trade deficits, and foreigners hold over half our public debt. To the extent foreigners keep buying Treasuries, it is because Europe's problems are worse. In short, we are the best-looking horse in the glue factory. "

You know the country is in bad shape and there is some economic danger when defenders of the Fed's policies have to justify themselves by pointing to Japan, a country which has been economically stagnate for decades, as an economic role model. Beware the bubble bond.